Derivative Financial Instruments

6 Months Ended

Jun. 30, 2011

Derivative Financial Instruments

Derivative Financial Instruments

Note 10.  Derivative Financial Instruments

The following table presents the Company’s derivative financial instruments, their fair values, and balance sheet location as of June 30, 2011 and December 31, 2010:

	June 30, 2011				December 31, 2010
Derivative Financial Instruments Not Designatedas Hedging Instruments1(dollars in thousands)	AssetDerivatives		Liability Derivatives		AssetDerivatives		LiabilityDerivatives
Interest Rate Lock Commitments	$	681	$	31	$	1,531	$	1,648
Forward Commitments	171		45		3,114		155
Interest Rate Swap Agreements	26,637		26,855		25,982		26,197
Foreign Exchange Contracts	223		22		264		106
Total	$	27,712	$	26,953	$	30,891	$	28,106

1  Asset derivatives are included in other assets and liability derivatives are included in other liabilities in the consolidated statements of condition.

The following table presents the Company’s derivative financial instruments and the amount and location of the net gains and losses recognized in the statements of income for the three and six months ended June 30, 2011 and 2010:

	Location of Net Gains	Three Months Ended						Six Months Ended
Derivative Financial Instruments Not Designated	(Losses) Recognized in the	June 30,						June 30,
as Hedging Instruments (dollars in thousands)	Statements of Income	2011			2010			2011			2010
Interest Rate Lock Commitments	Mortgage Banking	$	1,908		$	4,886		$	3,389		$	7,245
Forward Commitments	Mortgage Banking	(341		)	(1,689		)	(105		)	(2,008		)
Interest Rate Swap Agreements	Other Noninterest Income	339			(41		)	367			113
Foreign Exchange Contracts	Other Noninterest Income	743			667			1,640			1,413
Total		$	2,649		$	3,823		$	5,291		$	6,763

Management has received authorization from the Bank’s Board of Directors to use derivative financial instruments as an end-user in connection with its risk management activities and to accommodate the needs of its customers.  As with any financial instrument, derivative financial instruments have inherent risks.  Market risk is defined as the risk of adverse financial impact due to fluctuations in interest rates, foreign exchange rates, and equity prices.  Market risks associated with derivative financial instruments are balanced with the expected returns to enhance earnings performance and shareholder value, while limiting the volatility of each.  The Company uses various processes to monitor its overall market risk exposure, including sensitivity analysis, value-at-risk calculations, and other methodologies.

Derivative financial instruments are also subject to credit and counterparty risk, which is defined as the risk of financial loss if a borrower or counterparty is either unable or unwilling to repay borrowings or settle a transaction in accordance with the underlying contractual terms.  Credit and counterparty risks associated with derivative financial instruments are similar to those relating to traditional on-balance sheet financial instruments.  The Company manages derivative credit and counterparty risk by evaluating the creditworthiness of each borrower or counterparty, adhering to the same credit approval process used for commercial lending activities.

Derivative financial instruments are required to be carried at their fair value on the Company’s consolidated statements of condition.  As of June 30, 2011 and December 31, 2010, the Company did not designate any derivative financial instruments as formal hedging relationships.  The Bank’s free-standing derivative financial instruments have been recorded at fair value on the Company’s consolidated statements of condition.  These financial instruments have been limited to interest rate lock commitments, forward commitments, interest rate swap agreements, and foreign exchange contracts.

The Company enters into interest rate lock commitments for residential mortgage loans that the Company intends to sell in the secondary market.  Interest rate exposure from interest rate lock commitments is economically hedged with forward commitments for the future sale of residential mortgage loans.  The interest rate lock commitments and forward commitments are free-standing derivatives which are carried at fair value with changes recorded in the mortgage banking component of noninterest income in the Company’s consolidated statements of income.  Changes in the fair value of interest rate lock commitments and forward commitments subsequent to inception are based on changes in the fair value of the underlying loan resulting from the fulfillment of the commitment and changes in the probability that the loan will fund within the terms of the commitment, which is affected primarily by changes in interest rates and the passage of time.

The Company enters into interest rate swap agreements to facilitate the risk management strategies of a small number of commercial banking customers.  The Company mitigates this risk by entering into equal and offsetting interest rate swap agreements with highly rated third party financial institutions.  The interest rate swap agreements are free-standing derivatives which are carried at fair value with changes included in other noninterest income in the Company’s consolidated statements of income.  The Company is party to master netting arrangements with its institutional counterparties; however, the Company does not offset assets and liabilities under these arrangements for financial statement presentation.  Collateral, usually in the form of marketable securities, is posted by the counterparty with liability positions in accordance with contract thresholds.  As of June 30, 2011, the Company had net liability positions with its financial institution counterparties totaling $26.9 million.  The collateral posted by the Company for these net liability positions was not material.

The Company’s interest rate swap agreements with institutional counterparties contain credit-risk-related contingent features relating to the Company’s debt ratings or capitalization levels.  Under these provisions, if the Company’s debt rating falls below investment grade or if the Company’s capitalization levels fall below stipulated thresholds, certain counterparties may require immediate and ongoing collateralization on interest rate swaps in net liability positions, or may require immediate settlement of the contracts.  The Company maintains debt ratings and capital levels that exceed these minimum requirements.

The Company utilizes foreign exchange contracts to offset risks related to transactions executed on behalf of customers.  The foreign exchange contracts are free-standing derivatives which are carried at fair value with changes included in other noninterest income in the Company’s consolidated statements of income.